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CHAPTER 9
THE CAPITAL ASSET PRICING MODEL
9.1 THE CAPITAL ASSET PRICING MODEL
1. The CAPM and its Assumptions
The capital asset pricing model (CAPM) is a
set
of predictions concerning
equilibrium expected returns on risky assets. Harry Markowitz laid down the
foundation of modern portfolio management in 1952. The CAPM was developed
12 years later in articles by William Sharpe (1964),
John Lintner (1965), and Jan
Mossin (1966). The time for this gestation indicates that the leap from
Markowitz's portfolio selection model to the CAPM is not trivial.
We summarize the
simplifying assumptions
that lead to the basic version of the
CAPM in the following list. The fundamental idea is that individuals are as alike
as possible, with the notable exceptions of initial wealth and risk aversion. We
will see that conformity of investor behaviour vastly simplifies our analysis.
1.
There are many investors, each with an endowment (wealth) that is small
compared to the total endowment of all investors. Investors are
pricetakers
, in
that they act as though security prices are unaffected by their own trades. This
is the usual perfect competition assumption of microeconomics.
2.
All investors plan for one identical holding period. This behavior is
myopic
(shortsighted) in that it ignores everything that might happen after the end of
the singleperiod horizon. Myopic behavior is, in general, suboptimal.
3.
Investments are limited to a
universe
of publicly traded financial assets, such
as stocks and bonds, and to riskfree borrowing or lending arrangements. It is
assumed also that investors may borrow or lend any amount at a fixed, risk
free rate.
4.
Investors pay
no
taxes on returns and no transaction costs (commissions and
service charges) on trades in securities. (In reality, of course, we know that investors
are in different tax brackets and that this may govern the type of assets in which they
invest
. In such a simple world, investors will not care about the difference between returns
from capital gains and those from dividends.)
Furthermore, actual trading is costly,
and commissions and fees depend on the size of the trade and the good
standing of the individual investor.
5.
All investors are
rational
meanvariance optimizers, meaning that they all use
the Markowitz portfolio selection model to construct efficient frontier
portfolios.
6.
All investors analyse securities in the same way and share the same economic
view of the world. The result is
identical
estimates of the probability
distribution of future cash flows from investing in the available securities;
1
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View Full Documentthat is, for any set of security prices they all derive the same input list to feed
into the Markowitz model. Given a set of security prices and the riskfree
interest rate, all investors use the same expected returns, standard deviations
and correlations to generate the efficient frontier and the unique optimal risky
portfolio. This assumption is often referred to as
homogeneous expectations
or beliefs.
These assumptions represent the “if” of our “what if” analysis. Obviously, they
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 Spring '11
 john

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